S-Corps 101 (Part 1): An S-Corp Isn’t a Business Entity

S-Corps 101 (Part 1): An S-Corp Isn’t a Business Entity

This is the first post in a series of posts about S-Corps. We’ll explain what exactly is a “S-Corp” and how they came to be, when you should consider electing S-Corp status (read that here), and how you can reduce your tax liability by making an S-Corp election (read that here).

A Summary of Business Entities & Taxation

Historically, entrepreneurs only had two options to form a business entity (we will ignore LLCs for a moment, which are only a few decades old):

Option 1: Form a general partnership and (a) benefit from a reduced tax bill due to “pass-through” taxation, but (b) be subject to full personal liability for all business debts and liabilities; or

Option 2: Form a corporation and (a) benefit from limited personal liability for the business’ debts and liabilities; but (b) be subject to a higher tax bill due to “double-taxation.”

Obviously, neither option is ideal. One will result in more income but higher risk, the other will result less risk but lower income.

A Middle Ground – The “S-Corp”

In the 1950s President Eisenhower led the charge to make a middle option: allow a corporation to “pass through” its income while still benefiting from the limited liability associated with corporations. And in 1958, Congress agreed and enacted Subchapter S of the IRS Code.

As a result, business owners can form a corporation and make an S-Corp election and receive a lower tax bill and limited liability.

But here’s something important to remember – an S-Corp is not a business entity. When you form your business entity with your Secretary of State, you can choose a partnership, limited liability company, corporation, or non-profit corporation. But you cannot choose an “S-Corp.” That’s because it is merely a tax classification.

S-Corp Restrictions

It is very important to note that there are specific requirements you must meet if you want to take advantage of S-Cop taxation. And they are not ideal for many businesses, especially high-growth potential startups that want to raise venture capital.

According to the IRS, to qualify for S-Corporation status today a corporation must:

Be a domestic corporation

Have only allowable shareholders

May be individuals, certain trusts, and estates and

May not be partnerships, corporations or non-resident alien shareholders

Have no more than 100 shareholders

Have only one class of stock

Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

S-Corps 101 (Part 2): Should Your Business Make an S-Corp Election

Next week we will dive into whether your business should make an S-Election and explain why high-growth startups should not make an S-Election. (Read that post here.)

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Image: Adobe/TeddyandMia

*This article is very general in nature and does not constitute legal advice.